Deck 20: Capital Budgeting: Methods of Investment Analysis

Question 1

Which of the following is TRUE, concerning NPV?

A) When the NPV is positive, the sum of the cash flows from the project equal the initial investment.
B) When the NPV is negative, the sum of the cash flows from the project must also be negative.
C) The project just recovers the initial investment, discounted by the hurdle rate.
D) The IRR is less than the RRR when the NPV is positive, after using the RRR as the discount rate.
E) When the NPV is positive, the project recovers the initial investment and earns a return greater than the RRR.

Answer 1

When the NPV is positive, the project recovers the initial investment and earns a return greater than the RRR.

Question 2

Saturn Ltd. wants to automate one of its production processes. The new equipment will cost $180,000. In addition, Saturn will incur installation and testing costs of $5,000 and $8,500 respectively. The expected life of the equipment is 8 years and the salvage value of the equipment is estimated at $18,000. The annual cash savings are estimated at $32,000. The company's required rate of return is 14%. Ignore income taxes. What is the net present value of this investment?

A) ($25,246)
B) $80,500
C) ($11,746)
D) ($45,056)
E) ($38,746)

Answer 2

($38,746)

Question 3

Use the information below to answer the following question(s).
Neptune Ltd. wants to expand its operations by manufacturing a new product line. New equipment will cost $225,000. Incremental sales are estimated at $150,000 per year for 6 years. Variable costs of producing the new product line are 52% of sales and incremental annual fixed costs are $25,000. The equipment can be salvaged after 6 years for 16% of its original cost. The company's required rate of return for new projects is 18%. Ignore income taxes.

-What is the net present value of the Neptune Ltd. investment?

A) ($26,291)
B) ($47,277)
C) $225,536
D) ($60,613)
E) $93,000

Answer 3

($47,277)

Question 4

Use the information below to answer the following question(s).
Neptune Ltd. wants to expand its operations by manufacturing a new product line. New equipment will cost $225,000. Incremental sales are estimated at $150,000 per year for 6 years. Variable costs of producing the new product line are 52% of sales and incremental annual fixed costs are $25,000. The equipment can be salvaged after 6 years for 16% of its original cost. The company's required rate of return for new projects is 18%. Ignore income taxes.

-What is the internal rate of return of the Neptune Ltd. investment?

A) 13.62%
B) 12.75%
C) 10.00%
D) 6.86%
E) 18.00%

Question 5

Use the information below to answer the following question(s).

Hawkeye Cleaners has been considering the purchase of an industrial dry-cleaning machine. The existing machine is operable for three more years and will have a zero disposal price. If the machine is disposed of now, it may be sold for $30,000. The new machine will cost $200,000, an additional cash investment in working capital of $60,000 will be required and will be returned at the end of the project. The machine is expected to last 3 years and has an estimated disposal value at that time of $20,000. The new machine will reduce the average amount of time required to wash clothing and will decrease labour costs. The investment is expected to net $50,000 in additional cash inflows during the year of acquisition and $150,000 each additional year of use. These cash flows will generally occur throughout the year and are recognized at the end of each year. Income taxes are not considered in this problem.


-When the net present value method is used, only projects with ________ are ________.

A) negative net present value; acceptable
B) negative net future value; not acceptable
C) positive net future value; acceptable
D) positive net present value; acceptable
E) positive net value; not acceptable

Question 6

Use the information below to answer the following question(s).

Hawkeye Cleaners has been considering the purchase of an industrial dry-cleaning machine. The existing machine is operable for three more years and will have a zero disposal price. If the machine is disposed of now, it may be sold for $30,000. The new machine will cost $200,000, an additional cash investment in working capital of $60,000 will be required and will be returned at the end of the project. The machine is expected to last 3 years and has an estimated disposal value at that time of $20,000. The new machine will reduce the average amount of time required to wash clothing and will decrease labour costs. The investment is expected to net $50,000 in additional cash inflows during the year of acquisition and $150,000 each additional year of use. These cash flows will generally occur throughout the year and are recognized at the end of each year. Income taxes are not considered in this problem.


-Which of the following results of net present value analyses is the LEAST acceptable?

A) $(15,000)
B) $(1,000)
C) $12,000
D) $0
E) $20,000

Question 7

Investment A requires a net investment of $600,000. The required rate of return is 10 percent for the three-year annuity. What are the annual cash inflows if the net present value equals 0?

A) $184,842
B) $241,269
C) $249,791
D) $271,316
E) $360,000

Question 8

Weston Ltd. is considering investing in a new piece of equipment for its factory. It estimates that the machine will generate an additional $120,000 per year in revenues. The contribution margin on these incremental revenues is estimated at 40%. Incremental annual fixed costs are estimated to be $8,200. The equipment would have a salvage value of $14,000 at the end of 6 years. The company's required rate of return is 13%. What is the net present value of this investment if the equipment costs $250,000? (Ignore income taxes.)

A) $2,800
B) ($51,393)
C) $204,803
D) $11,768
E) ($84,173)

Question 9

Next Service Centre is considering purchasing a new computer network for $82,000. It will require additional working capital of $13,000. Its anticipated eight-year life will generate additional client revenue of $33,000 annually with operating costs, excluding depreciation, of $15,000. At the end of eight years, it will have a salvage value of $9,500 and return $5,000 in working capital. Taxes are not considered.
Required:
a. If the company has a required rate of return of 14%, what is the net present value of the proposed investment?
b. What is the internal rate of return?

Question 10

Anderson Equipment Manufacturing produces equipment for the natural gas industry. The company management is considering purchasing new controllers for the fabricating machines. The new controllers are expected to increase efficiency and product quality. The engineering staff estimate that annual net cash savings from increased efficiency will be $35,000 per year for four years. The existing controllers can be sold for $8,000. The new controllers have a purchase price of $75,000 and will require installation costs in the amount of $4,500. The annual software contract for the new controllers is $1,700; the controllers will be depreciated using the straight-line method. The salvage value of the new controllers at the end of four years is estimated to be $10,000. The company has a required rate of return of 15%.
Required:
a. Determine the net present value of the investment in the new controllers.
b. Calculate the internal rate of return of the investment in the new controllers.

Question 11

Mercury Ltd. is considering purchasing laser equipment for $72,000. The machine will require additional working capital of $8,000. Its anticipated seven-year life will generate additional revenue of $31,000 annually with operating costs, excluding depreciation, of $14,000. At the end of seven years it will have a salvage value of $9,760 and return $8,000 in working capital.
Required:
a. If the company has a required rate of return of 12 percent, what is the net present value of the proposed investment?
b. What is the internal rate of return?

Question 12

Retail Outlet is looking for a new location near a shopping mall. It is considering purchasing a building rather than leasing, as it has done in the past. Three retail buildings near a new mall are available but each has its own advantages and disadvantages. The owner of the company has completed an analysis of each location which includes considerations for the time value of money. The information is as follows:

The owner does not understand how the location with the highest percentage return has the lowest net present value.
Required:
Explain to the owner the probable cause(s) of the comparable differences.

Question 13

A capital proposal is projected to result in annual savings of $25,000. What is the after-tax cash flow if the tax rate is 35%?

A) $25,000
B) $16,250
C) $8,750
D) $7,500
E) $33,750

Question 14

Wilf Company acquired an additional Class 10 (30% declining balance) asset for $60,000. The UCC at the beginning of the year was $100,000. The maximum CCA in the current year is

A) $48,000.
B) $24,000.
C) $45,000.
D) $37,500.
E) $39,000.

Question 15

The three factors that generally influence depreciation under IFRS/ASPE are: amount allowable for depreciation, allowable life of asset, and allowable methods of depreciation. In Canada, for tax purposes

A) the amount allowable for CCA is the cost of the asset, and, the allowable life of asset and the amount of salvage value are determined by its Class under the Income Tax Act.
B) the amount allowable for CCA is the cost of the asset; the tax-based depreciation rate is determined by the Class of the asset under the Income Tax Act, and neither the estimated life of asset nor the amount of estimated salvage value are relevant in calculating the CCA claim.
C) the allowable depreciation for tax purposes (CCA) is increased for the first year only.
D) depreciable assets are placed in various classes by the Income Tax Act, based on their estimated salvage value.
E) in the year of acquisition of new assets into an existing pool the allowable CCA claim is based on 50% of all the assets in the pool.

Question 16

Use the information below to answer the following question(s).
Albernie Ltd. purchased a CCA Class 8 (CCA rate of 20%) item of equipment for $90,000. The equipment was the only item in the Class 8 capital cost allowance pool. The equipment is expected to generate savings in the amount of $40,000 per year. The company uses straight-line depreciation, estimates a 3 year useful life with $20,000 salvage value for the new equipment. The tax rate is 35%, and Albernie has a required rate of return of 9.0%.

-What is the maximum capital cost allowance that Albernie Ltd. can claim in year 2, if the maximum was claimed in year 1?

A) $11,200
B) $12,600
C) $18,000
D) $16,200
E) $14,400

Question 17

Use the information below to answer the following question(s).
Albernie Ltd. purchased a CCA Class 8 (CCA rate of 20%) item of equipment for $90,000. The equipment was the only item in the Class 8 capital cost allowance pool. The equipment is expected to generate savings in the amount of $40,000 per year. The company uses straight-line depreciation, estimates a 3 year useful life with $20,000 salvage value for the new equipment. The tax rate is 35%, and Albernie has a required rate of return of 9.0%.

-What is present value of the after-tax savings that Albernie Ltd. expects during the useful life of the equipment?

A) $65,814
B) $101,252
C) $81,257
D) $50,370
E) $42,188

Question 18

Use the information below to answer the following question(s).
Albernie Ltd. purchased a CCA Class 8 (CCA rate of 20%) item of equipment for $90,000. The equipment was the only item in the Class 8 capital cost allowance pool. The equipment is expected to generate savings in the amount of $40,000 per year. The company uses straight-line depreciation, estimates a 3 year useful life with $20,000 salvage value for the new equipment. The tax rate is 35%, and Albernie has a required rate of return of 9.0%.

-What is present value of the tax shield that Albernie Ltd. can expect from the equipment?

A) $ 18,124
B) $ 17,099
C) $ 12,816
D) $ 7,667
E) $ 10,222

Question 19

Use the information below to answer the following question(s).
Albernie Ltd. purchased a CCA Class 8 (CCA rate of 20%) item of equipment for $90,000. The equipment was the only item in the Class 8 capital cost allowance pool. The equipment is expected to generate savings in the amount of $40,000 per year. The company uses straight-line depreciation, estimates a 3 year useful life with $20,000 salvage value for the new equipment. The tax rate is 35%, and Albernie has a required rate of return of 9.0%.

-What is present value of the salvage value that Albernie Ltd. is expecting from the equipment?

A) $ 15,897
B) $ 20,000
C) $ 15,444
D) $ 11,574
E) $ 14,169

Question 20

Use the information below to answer the following question(s).
Albernie Ltd. purchased a CCA Class 8 (CCA rate of 20%) item of equipment for $90,000. The equipment was the only item in the Class 8 capital cost allowance pool. The equipment is expected to generate savings in the amount of $40,000 per year. The company uses straight-line depreciation, estimates a 3 year useful life with $20,000 salvage value for the new equipment. The tax rate is 35%, and Albernie has a required rate of return of 9.0%.

-What is the net present value of the Albernie Ltd. investment in equipment?

A) $ 1,480
B) $ (1,075)
C) $ 89,799
D) $ 8,357
E) $ 9,382

Question 21

Clock Manufacturing Company purchased a new piece of equipment at a cost of $60,000 at the beginning of the year. For tax purposes the machine is a Class 8 asset (20% declining balance). The company has a 34 percent income tax rate. Assume that the company has no other Class 8 assets during the period.
Required:
a. Compute the amount of tax savings from CCA for the first three years.
b. Compute the amount of tax savings from CCA for the first three years using a required rate of return of 12 percent.

Question 22

Headwaters Ltd. is considering purchasing a new asset. It has a cost of $1,350,000, an expected 6 year life and a salvage value of $90,000. The equipment would qualify as a class 8 (20% CCA) asset and Headwaters has a required rate of return of 11% and an effective tax rate of 32%.
Required:
Calculate the tax shields that are generated from the purchase of this asset. Assume the asset will be placed in a pool and the pool will continue upon disposition. For tax purposes the disposition will occur on day 1 of Year 7. What is the net tax effect of the asset acquisition?

Question 23

Johnson's Mini Mart is considering the purchase of a new electronic bar code scanner that will keep detailed records of every sale transaction. The scanner is likely to have little effect on operating revenues and expenses. Its acquisition is primarily for increasing management information about sales. The scanner costs $4,600 and would be included in Class 8 for tax purposes. Johnson's accountant has stated that due to the fast write-off of Class 8 assets (20% CCA rate), its real cost is less than $4,600.
Due to technological obsolescence, it would have zero salvage value.
Required:
a. Since the bar code scanner cannot produce a profit or even show short run savings, should it even be evaluated as a capital budgeting expenditure? Explain.
b. Explain whether or not the real cost is less than $4,600.
c. If the company has a 40 percent tax rate and a 10% discount rate, compute the real cost of the bar code scanner. Assume there would be other assets in the class.

Question 24

Windpower Systems Maintenance Ltd. purchased a CCA Class 10 (CCA rate of 30%) vehicle for $360,000. The vehicle was the only item in the Class 10 capital cost allowance pool. The vehicle is expected to generate net cash income, excluding any tax effects, in the amount of $70,000 per year. The company uses straight-line depreciation, estimates a 6 year useful life with a $40,000 salvage value for the new vehicle at the end of year 6. The marginal tax rate is 35% and the company's average tax rate is 25%. Management requires a rate of return of 15.0%. Assume that cash flows occur at the end of the year.
Required:
a. What is the unamortized capital cost at the beginning of year 2 if the maximum capital cost allowance that is allowed is taken in the first year?
b. What is the net present value of the investment in the vehicle?

Question 25

A project has a net initial investment of $500,000 and the cash flows cover five years. The project involves replacing an old machine with a new machine at the same time. Which of the following is TRUE based on the above assumptions, in NPV analysis?

A) The book value of the old machine is relevant.
B) Recurring operating cash flows cannot be positive and negative.
C) Incremental working capital investment is irrelevant.
D) Any cash received from the disposal of the old machine would be a relevant cash flow for end of year 1.
E) Errors in forecasting the terminal disposal price of the new machine are seldom critical on long-duration projects.

Question 26

A company is considering purchasing new equipment. The equipment will allow the company to expand into a new product line. The equipment will be installed in the company's existing facility. Which of the following cash flows would NOT be relevant to the decision to acquire the new equipment?

A) factory rent allocated to the new product line
B) labour costs to operate the new equipment
C) revenues from expanded production
D) annual maintenance cost on the new equipment
E) the salary of the manager hired to oversee the new product line

Question 27

ABC Boat Company is interested in replacing a moulding machine with a new improved model. The old machine has a salvage value of $20,000 now and a predicted salvage value of $4,000 in six years, if rebuilt. If the old machine is kept, it must be rebuilt in one year at a predicted cost of $40,000. The new machine costs $160,000 and has a predicted salvage value of $28,000 at the end of six years. The new machine will generate cash savings of $40,000 for each of the first three years and $20,000 for each year of its remaining six-year life. Ignore income taxes.
Required:
What is the net present value of replacing the old machine if the company has a required rate of return of 14 percent?

Question 28

Crofton Inc. is evaluating new machinery in its foundry. The machinery would replace existing equipment. The new machinery would cost $230,000, would last 5 years, and would have a salvage value of $28,000. The existing machinery currently has a net book value of $52,000 and could be sold for $38,000. If kept, the old machine would have a salvage value of $6,000 in 5 years' time. The new machinery is expected to lower direct labour costs by $18,000 per year. The current variable overhead rate is 120% of direct labour. Other annual cost savings are projected to be $30,000. Due to the reduction in the production cycle time, working capital requirements will decrease by $25,000 during the life of the new machine. Ignore income taxes.
Required:
a. Compute the net present value of replacing the existing equipment at a 9 percent required rate of return.
b. Compute the internal rate of return.

Question 29

Samuel Manufacturing Inc. is evaluating new machinery in its factory. The machinery would replace existing equipment. The new machinery would cost $430,000, would last 6 years, and would have a salvage value of $36,000. The existing machinery currently has a net book value of $72,000 and could be sold for $65,000. If kept, the old machine would have a salvage value of $5,000 in 6 years time. The new machinery is expected to lower direct labour costs by $22,000 per year. The current variable overhead rate is 120% of direct labour. Other annual cost savings are projected to be $15,000. Due to the reduction in the production cycle time, working capital requirements will decrease by $8,000 during the life of the new machine. Ignore income taxes.
Required:
a. Compute the net present value of replacing the existing equipment at a 12 percent required rate of return.
b. Compute the internal rate of return.
c. Comment on the efficacy of the use of internal rate of return versus net present value in making this decision.

Question 30

Use the information below to answer the following question(s).
Saturn Ltd. wants to automate one of its production processes. The new equipment will cost $180,000. In addition, Saturn will incur installation and testing costs of $5,000 and $8,500 respectively. The expected life of the equipment is 8 years and the salvage value of the equipment is estimated at $18,000. The annual cash savings are estimated at $32,000. The company uses straight-line depreciation and has a required rate of return of 14%. Ignore income taxes.

-What is the payback period for the investment Saturn Ltd. is considering?

A) 5.63 years
B) 5.78 years
C) 6.05 years
D) 5.26 years
E) The project does not payback.

Question 31

Use the information below to answer the following question(s).
Saturn Ltd. wants to automate one of its production processes. The new equipment will cost $180,000. In addition, Saturn will incur installation and testing costs of $5,000 and $8,500 respectively. The expected life of the equipment is 8 years and the salvage value of the equipment is estimated at $18,000. The annual cash savings are estimated at $32,000. The company uses straight-line depreciation and has a required rate of return of 14%. Ignore income taxes.

-What is the accrual accounting rate of return for the investment Saturn Ltd. is considering?

A) 5.2%
B) 16.5%
C) 4.0%
D) 5.9%
E) 11.0%

Question 32

Fabian Company is considering the purchase of a piece of materials-handling equipment:

Required:
a. Calculate the payback period.
b. Calculate the accrual accounting rate of return.

Question 33

Fisher Ltd. is considering the purchase of new equipment. Details of the investment follow:

Required:
a. Calculate the payback period.
b. Calculate the accrual accounting rate of return based on the initial investment.
c. Calculate the net present value.

Question 34

Hiroshi Inc. is evaluating 3 investment alternatives. Each alternative requires an initial investment cash outflow of $176,000 and is to be depreciated on a straight-line basis ($6,000 salvage value). Ignore income taxes. Cash flows for the various investments are summarized below:

The company has a required rate of return of 11.2%
Required:
a. rank each alternative based on NPV
b. rank each alternative based on IRR
c. rank each alternative based on accrual accounting rate of return using average annual cash flows
d. evaluate each project based on the payback periods

Question 35

Supply the missing data for each of the following proposals.
‪

Question 36

Book & Bible Bookstore desires to buy a new coding machine to help control book inventories. The machine sells for $36,586 and requires working capital of $4,000. Its estimated useful life is five years and will have a salvage value of $4,000. Recovery of working capital will be $4,000 at the end of its useful life. Annual cash savings from the purchase of the machine will be $10,000. Ignore income taxes.
Required:
a. Compute the net present value at a 14 percent required rate of return.
b. Compute the internal rate of return.
c. Determine the payback period of the investment.

Question 37

Hentgen and Ferraro, baseball consultants, are in need of a microcomputer network for their staff. They have received three proposals, with related facts as follows:

The company uses straight-line depreciation for all capital assets. Ignore income taxes.
Required:
a. Compute the payback period, net present value, and accrual accounting rate of return using average annual income, for each proposal. Use a discount rate of 14 percent.
b. Rank each proposal 1, 2, and 3 using each method separately. Which proposal is best? Why?

Question 38

Jefferson Ltd. is considering the acquisition of new production equipment. If purchased, the new equipment would cost $1,850,000. Installation and testing costs would be $35,000 and $25,000 respectively. Once operational, the equipment will cause an increase in working capital of $120,000. The new equipment is expected to generate increased annual sales of $720,000. Variable costs to operate the machine are estimated at 42% of sales and annual fixed costs would be lowered by $75,000. The equipment has an estimate 6 year life and a salvage value of $90,000. The company requires an 11% return on its investments. Ignore income taxes.
Required:
a. Compute the net present value.
b. Compute the internal rate of return.
c. Determine the payback period of the investment.

Question 39

Sam's Structures desires to buy a new crane and accessories to help move and install modular buildings. The machine sells for $75,000 and requires working capital of $10,000. Its estimated useful life is six years and it will have a salvage value of $17,560. Recovery of working capital will be $10,000 at the end of its useful life. Annual cash savings from the purchase of the machine will be $20,000.
Required:
a. Compute the net present value at a 12% required rate of return.
b. Compute the internal rate of return.
c. Determine the payback period of the investment.

Question 40

Pender Ltd. is analyzing two proposals for cleaning contracts for the next 3 year period. The company has 200,000 square metres of floor space which is currently 75% occupied. It expects that occupancy will increase to 82% in year 2, and 90% in year 3.
The proposal from Company A is as follows:
Six janitors will be used at a budgeted annual salary of $26,000/each. These salaries are expected to remain static over the 3 year period. One supervisor will be used at an annual salary of $38,000. Salary increases for the supervisor will be $1,500 per year. Indirect labour costs are at 12.5% of salaries. Indirect material costs will be at a rate of $0.20 per square metre occupied. Fixed costs of $7,200 per year will also be charged to Pender by the contractor.
The proposal from Company B is as follows:
A rate of $1.40 per square metre occupied will be charged. In addition a part time supervisor will be required at an annual cost of $24,000 plus benefits at 15%. Fixed costs of $4,600 per year will be charged to Pender by Company B. No increases are forecast through the three year period.
Additional information:
Company A is the existing contractor. If the agency does not choose Company A, it must pay Company A a flat $8,000 on termination of its services. This payment would be made immediately.
Assume cash flows occur at the end of the year unless otherwise stated. The discount rate to be used is 6% and is not expected to change in the next 3 years.
Required:
Evaluate these two proposals using the net present value method.

Question 41

Xanadu Manufacturing Ltd. (XML) has two main customers in its' Eastern Canada division. The current year is 2016 and the company is evaluating its' customers current and projected profitability taking the time value of money into consideration. XML has a required rate of return of 12%.
The customer gross margins projected for the five year period ending 2020 are as follows:

XML has identified the following customer related activities and their rates:

The company has the following information for 2016 regarding the three customers:

The ratio of activity costs to gross margin is expected to be the same for the years after 2016.
Required:
a. Determine the profitability of each customer for 2016 using activity-based costing.
b. Present a table showing the contribution to profit of each customer for each year assuming that the 2016 ratio of activity costs to gross margin is maintained. Include a column for the five year total.
c. Use the present value method to discount each customer's contribution to profit. Assume end of period payments.
d. Provide two qualitative measures that can be effective in evaluating customers.

Question 42

A Company wants to buy a moulding machine that can be integrated into its computerized manufacturing process. It has received three bids for the machine and related manufacturer's specifications. The bids range from $3,500,000 to $3,550,000. The estimated annual savings of the machines range from $260,000 to $270,000. The payback periods are almost identical and the net present values are all within $8,000 of each other. The president just doesn't know what to do about which vendor to choose; all the selection criteria are so close together.
Required:
What suggestions do you have for the president?